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How WESCO International Surprised the Stock Market

Distributing industrial supplies when U.S. industrial production is in a recession is a tough business: Just ask management at WESCO International Inc.(NYSE: WCC). It gets worse. Much of WESCO's end market consists of precisely the kind of industries (oil and gas, mining, heavy industries, and more) which have largely been responsible for the slowdown in the industrial sector.

However, this quarter it was the turn of its construction end markets to disappoint. What happened, and why?

Net sales declined 3.6%, a figure below the bottom end of the guidance range for a decline of 3% to flat.

Operating margin was 5%, compared to the guidance range of 4.9% to 5.3%.

Income from operations declined 12.9% to $92.6 million.

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As you can see above, sales declined more than expected, and margin came in at the low end. In this context, it's no surprise that management lowered its expectations for the full year:

Full-year sales forecast to decline by 3% to 2%, compared to a previous forecast for a decline of 2% to flat.

Full-year operating margin now forecast lower at 4.5% to 4.6%, compared to a previous forecast of 4.6% to 4.8%.

Adjusted diluted earnings per share now expected in the range of $3.75 to $3.90, compared to a previously forecast range of $3.85 to $4.10.

Clearly, the difficult third quarter took its toll, and management was forced to cut guidance across the board. In fact, the only positive change to expectations was that free cash flow is now expected to represent more than 125% of adjusted net income, compared to a previous forecast of more than 100%.

WESCO is doing a good job of generating cash in a slowdown. But don't get too excited, because it's partly to do with taking on less inventory and reducing accounts payable -- things are likely to reverse if sales improve.

What happened with WESCO's quarter?

Going into the results, investors had cause to be blase about events. After all, when WESCO's industrial-supply peerFastenal Company(NASDAQ: FAST)reported, Fastenal's CEO Dan Florness outlined end markets that were little changed in the quarter. However, Fastenal is more of a general industrial supplier, while WESCO has more exposure (direct and indirect) to areas of relative weakness in the industrial economy.

A quick look at organic sales growth by end market demonstrates weakness across each area: All reported organic sales declined. However, as stated above, management expected a sales decline in the quarter, it's just that construction sales in particular were disappointing. WESCO CEO John Engel put it clearly in the earnings release: "Sales were below expectations, reflecting a decline in construction in both the U.S. and Canada."

Image source: WESCO International presentation.

As you can see above, industrial sales (in which the company has heavy exposure to oil and gas, metals, and mining customers) has had a difficult time in the last two years -- it's no surprise to see ongoing weakness there. Moreover, management claimed that outside of construction, its end markets performed as expected.

Construction weakness

Regarding the weakness in construction, a few themes emerged from the earnings report:

Outside of commodities (oil and gas, metals, and mining) the company continues to expect a "modest uptrend in nonresidential construction."

Nonresidential construction activity is still significantly below the 2008 peak.

When pushed on the issue, WESCO's management candidly admitted that results were disappointing; however, it claimed they were notdue to canceled activity, but rather to project-timing issues causing delays. Here again, it appears that exposure to oil and gas and the industrial sector (specifically, industrial construction) has hurt the company.

Looking ahead

All told, a combination of factors hit WESCO in the quarter. It's especially disappointing because just last quarter, management had guided analysts toward its construction markets being between flat and up low single digits for the full year (a stronger outlook than that given at the end of its fiscal 2015).

Going forward, investors will be hoping industrial conditions turn positive, so supply companies like Fastenal and WESCO can flourish again.

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